One of my friends was over this weekend and she recently got a new job. She is contributing to her company’s 401(k) plan – which is excellent!
She met with a few folks from HR to figure out whether a traditional 401(k) or Roth 401(k) would be best. The folks that she met with recommended the Roth 401(k) because she is making less money now and he has the potential to make more money in the future.
The argument is that she can contribute now with post-tax dollars while her taxes are low and save money on her taxes in the future by getting the write off from the traditional 401(k). The first thought that popped into my mind as we discussed this topic was: this will make an awesome blog post.
Before we dive into the benefits and calculations of a traditional 401 (k) vs a Roth 401 (k), and if what I discussed above doesn’t make complete sense, you should watch this short video before you download the 401 (k) calculator. Once done with the video the information below will become clearer.
Which One Should You Invest In? 401(k) vs. Roth 401(k)?
- Some of the things that I will review in this post include:
- What is the main difference between a Roth 401(k) and a Traditional 401(k)?
- Is the recommendation provided by my friend’s HR department the best advice to follow?
The Difference Between a Roth 401(k) and Traditional 401(k)
Contributions with post-tax dollars versus pre-tax dollars. With a Traditional 401(k), the money you contribute is not taxed and reduces your taxable income. With a Roth 401(k), the contributions you make are with post-tax dollars. Think of it as money you contribute after you receive the money from your paycheck.
A Math Example of the Difference Between the 401 (k) and Traditional 401 (k)
Let’s say that you make $50,000/year and you contribute $1,000/month into your Roth 401(k).
At the end of the year, you will have contributed $12,000, and because you didn’t receive a tax deduction, you will pay taxes on all $50,000 of your income. This equates to a little over $8,200 just in federal taxes.
Using the same example, but now you contribute to a traditional 401(k). At the end of the year, you will have contributed $12,000. Instead of being taxed for making $50,000, you reduced your taxable income to $38,000.
So what does this mean? It means you only paid about $5,200 in federal income tax, and it means that you saved yourself $3,000 in taxes – that is $3,000 in your pocket that Uncle Sam can’t take away. Let’s dig in a little further…
Traditional 401(k) or Roth 401(k).
When I was first out of school, I contributed to a Roth 401(k) because I followed the “traditional” recommendation. Most people argue that you should contribute to a Roth 401(k) when you are young because your income, and hence your tax rate, is lower.
Once you begin to make more money and pay more in taxes because of a higher effective tax rate, you can start to contribute to a traditional 401(k). This will reduce your taxable income.
Additionally, in retirement, your tax rate will likely be lower because you will live off of less. Therefore, it makes sense to delay paying the taxes until your tax rate is lower.
Predicting Your Future Tax Rate
Trying to predict what your tax rate will be in retirement is risky.
- First, you have no idea what your situation in retirement will be like. If all of your money is in a traditional 401(k) and you need to tap it for a big expense, you could lose a great deal of money to taxes.
- Second, you have zero control over what the government will do regarding tax law changes.
If you can guess what your tax rate will be, you can make the decision now whether it makes more sense to pay taxes now or in the future. But no one can predict the future
Now the folks on the early retirement journey know that traditional 401(k) is the way to go because they are all about tax efficiency. They are probably saving into a taxable account, in addition to their traditional 401(k) and traditional or Roth IRA. They will live off of their taxable account while slowly converting their traditional IRA into their Roth IRA.
You could also build a Roth IRA conversion ladder to minimize taxes in early retirement. But, we’ll dive into that in greater detail below.
The Math Between a Traditional 401 (k) vs Roth 401 (k) – The 401 (k) Calculator
The math is pretty straightforward. Here are three examples that display the tax differences for someone making $50,000 and contributing to a Roth 401(k) and a Traditional 401(k).
The first example uses a contribution of $6,000/year, the second example uses $12,000/year, and the final example has a person maxing out their 401(k) – $18,000/year.
Traditional 401(k) or Roth 401(k) Calculator and Spreadsheet
You can see how much money you can save yourself on taxes if you contribute to a traditional 401(k). What is even better is if you take that money you saved in taxes and put that money into another retirement/investment account. Using the last example, take the $7k you saved in taxes and throw it into a Roth IRA (yes I know the current yearly max is $5,500). In 20 years, you will have over $1 million between your traditional 401(k) and your Roth IRA!
The best advice I can give, which was given to me early in my career, is to have multiple buckets. I would save more into accounts that can reduce your taxable income so you have more of the money you work so hard to earn. If you can, take that extra money you are saving and invest it.
Maybe invest in a Roth IRA or a taxable account so you have money if you need it in a tax-free bucket (because you already paid the taxes on the contributions!)
You saw from my last example of how saving the money you save on taxes can really add a nice cushion to your retirement fund. The example also gives your two different buckets to dip into in retirement – one tax-free and one taxed account. I encourage you to download the spreadsheet and take a look at your situation
If you enjoyed this post, you might also enjoy this post: How to Become a Decamillionaire, Grow your Net Worth to $10 Million, and Join the 1% Club
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Also, I published a book during the summer of 2018, “The Kickass Entrepreneur’s Guide to Investing, Three Simple Steps to Create Massive Wealth with Your Business’s Profits.” It was number 1 on Amazon in both the business and non-fiction sections. You can get a free copy here.
This post was written by Ashley Jenkins, a guest blogger on The Kickass Entrepreneur.
*** Disclaimer – The information provided on this site is based on my own personal experience and is not to be construed as professional advice. I am not a financial advisor or planner, nor am I a CPA. The contents of this site and the resources provided are for informational and entertainment purposes only and do not constitute financial, accounting, or legal advice. The author is not liable for any losses or damages related to actions or failure to act related to the content on this website.